DABERIAM XXXIV

October 2007

As anticipated in August, some of the banking train wrecks have taken place as well as quite a few corporate accidents. There are still some to come. 

The rating agencies review structured securities on a 90-day cycle. One can, therefore, anticipate considerable write-downs over the next three months and beyond. When an instrument is downgraded from, say, AA quality to BB it falls into the sub-prime category causing banks regulatory problems. It is worth noting that Basle II exacerbates these problems as the liquidity calculations are more and more defined by letter ratings. 

So far the large financial institutions have not yet had to unload structured debt instruments and while write-offs have been announced, there has been very little testing of the real market for complex paper. The pressure and the problems will grow as we get to the 31st December, and as I mentioned last July, year-end reporting requirements will discourage bank chairmen etc. from having to explain why they are holding sub-prime paper. It is easier to take a loss and move on. 

Through August, September and October we have seen the market dip and then recover. As the faster moving hedge funds have rebalanced their books, we can now expect a good run up of stocks and shares as well as commodity prices as we go into the year end, the usual trend as interest rates trend down.

Global Economic Indicators

World Economic Growth  (World Bank figures)	2006	4.00%	2005	3.60%	2004	3.40%
Base rates: 31 Oct 2007	USD	4.50%	EUR	4.00%	GBP	5.75%
MSCI World Equity Index	30/10/2007	299.601	29/12/2006	235.243	YTD %	27.36%
Gold (PM London Fix $ per ounce)	30/10/2007	789.50	29/12/2006	635.70	YTD %	24.19%
Oil (WTI Crude $ per barrel)	30/10/2007	94.54	29/12/2006	61.06	YTD %	54.83%

While the phenomenon of the connectivity of the new world creates sort term gyrations, it does seem to make it easier to predict a trend. However, this global connectivity is making it exceedingly difficult for Central Banks to act with foresight, if they ever could.

Five years of deflationary pressures caused by the export of goods from the low cost economies of Asia to the West is coming to an end; the dollar balances and the Euro balances being built up by China, India and the Middle East are of themselves creating pressures that the banking system cannot control. The current financial crisis, a product of excessive liquidity, an inverted yield curve and the unintended consequence of regulation, is forcing US interest rates down which in turn will continue to depress the dollar. While European interest rates continue to remain steady or tend to rise, the full force of the financial crisis has not yet struck home. This is pushing up the Euro against the dollar. 

China is raising its interest rates to damp down its now nearly out of control expansion. This will force the RMB and the dollar to decouple. Until now the Chinese authorities have been happy to make money by adding to their dollar surpluses to invest in US Government paper. A profitable transaction as the interest rate in the US has been higher than in China. It’s doubtful that the Chinese authorities will be happy to continue this process for much longer as they are now losing money on the exchange rate and will start to lose money as the interest rate differential reverses. 

While the present trends of declining Western interest rates and rising Asian interest rates are likely to continue for the next six months or so, as the financial markets work out their problems it is likely that stock market values and commodity prices will continue to rise. The Western economies are also benefiting from Asian and Middle Eastern growth which is softening what otherwise would be a more rapid economic slowdown. 

The whole system could, however, unravel very rapidly when the RMB re-values. The impact of a revaluation will be a dramatic increase in prices in the Western economics as the supply of goods to the retail market is re-priced to the new exchange rates. 

Today the Central Banks in the US and Europe are more concerned about the immediate problems of the financial crises but if inflation indices start to rise faster, interest rates will rise with them. 

All in all it looks as though we have a built in run up in the equity markets, particularly for companies involved in global trade and supplying industry with raw materials and the rise in equity markets around the world, which very much includes the Asian markets, is likely to continue until the link in the RMB/US$ chain is broken, at a guess, next Autumn. 

But it is always dangerous to make predictions - as Mark Twain said - “particularly about the future.” 

But for the moment, the future seems particularly clear!

Damon de Laszlo 
October 2007

DABERIAM XXXIII

August 2007

Last month I commented that we were at the beginning of the silly season, we are now well into it. While a credit crisis has been brewing for some time, the actual crisis - to mix metaphors - the blue touch paper was lit by Bear Sterns, who appeared naked in the market by admitting they had come unstuck with a fund, whose gearing beggars belief. 

The natural high volatility of the period took a turn for the extreme and it is in the extremes that the fault lines are revealed. The lamest of all excuses are appearing regularly; that what is happening is a once in 10,000 years event. From the comments it would appear that there are a lot of bright stars in the financial world who were apparently only born yesterday. But such is the normal situation when excess becomes the norm in financial markets. The blame this time looks as though it will be heaped on the rating agencies, not the “sophisticated” buyers of structured debt instruments and other high octane investments. 

Central Bank tightening usually continues until there is a crisis and we now have one. The lack of confidence in the credit markets will take some time to unwind. The effect on the US housing and property market where mortgages of any kind have become unavailable has yet to move across the Atlantic into the UK and European markets. One can expect among others, one big German bank and one of the UK banks, probably one that was once a Building Society to discover they have a funding black hole. For some time these old institutions have found it easier to borrow money “in the markets” rather than from high street depositors, who require a little bit of servicing, something that is in short supply in the banking industry.

The Central Banks around the world have so far performed excellently in providing liquidity to reduce the panic in the institutional markets but we can expect to see over the next six to nine months some large holes appear in the balance sheets of some well known financial institutions.

The perverse effect in the short term of the unwinding of borrowing excesses will be for share prices in good sound companies to be driven down as funds are forced to generate liquidity from the only assets they can sell. This will probably include the driving down of commodity prices; for example, many Hedge Funds have very long positions in commodities such as oil. On the other side the same funds that were short, predictably bad companies will have to cover, so driving up their share prices, leading to more extreme volatility. 

Underlying the blood bath, however, is the inexorable growth in the Asian economies led by China. While there is a lot of noise in the markets around the world, the underlying signal is economic growth in Asia, which is unlikely to be derailed by excesses in the western financial markets. 

Interest rates in the short term will be pushed down by Central Banks to deal with the current liquidity crisis but the long term upward trends in commodity prices and the inexorable rise in the price of goods from Asia is likely to continue. The upward trend in interest rates will resume next year when the markets have stabilised, bringing to an end the period of cheap money that has favoured the recent growth in structured products.

Anyone needing to borrow money in the short term is going to find it a painful experience, a reverse of the trend of the last five years. Having said that, well run businesses that have good management who understand their industries will continue to prosper. The pain will be experienced by industries who have indulged or been forced to indulge in financial engineering to puff up their profitability. Expect companies who have fallen to the private equity tigers to have a particularly torrid time.

It will be an interesting world while the excesses of financial engineering are burned off and there are certainly some more financial train-wrecks around, but the medium term outlook is on the whole rather clearer than it was earlier on this year! The Asian tigers will become the clear drivers of the world economy.

Damon de Laszlo 
August 2007

DABERIAM XXXII

July 2007

Mid-July and the beginning of the silly season, when we expect an increase of volatility in the markets, i.e. small amounts of news producing disproportionate effects. Volatility also seems to be being exacerbated by the enormous increase in computer programme trading and the huge amounts of money flowing across the main exchanges but also probably more importantly into the burgeoning derivative exchanges, that are driven by enormously complex algorithms that take advantage of minute movements. Many of the trades made by these complex beasts last for fractions of a second and try and trap movements that are measured by the number of noughts after the decimal point. It should be a fun, if that is the right word, few months.

Underneath the froth, the inexorable upward trend in interest rates around the world, with the possible exception of America, will continue to stress the economic system. While world liquidity generated by the shift of resources to the Middle East and Asia is funding some market excesses, the re-rating of debt instruments by Moody’s and others, is likely to destroy enormous amounts of value held by institutions that have bought sub-prime debts and other instruments constructed on its back. Moves by the rating agencies that I anticipated in January have now become a subject of journalistic debate. The danger here is that large financial institutions will start to unload some of the paper they are holding as their finance departments start to consider their year-end reporting requirements. This will create problems in market liquidity as we approach the year-end. 

Markets will also be unsettled as the retail and house-building sectors feel the effects of a reduction in consumer expenditure as higher costs of fuel, food and interest take a larger share of the consumer’s budget. The increase in prices of Chinese sourced retail products will also affect consumer consumption, or retail profits if the prices aren’t passed on.

Asian growth is inexorably driving up prices of all commodities where the shortage of supply in virtually all areas will take five to ten years to correct. The volatility in individual prices created by financial institutions trading the commodities and their derivatives, will continue to produce very confusing signals.

In the oil and gas market volatility is being exacerbated by the activities of Mr Putin in Russia who has effectively taken control of European gas supplies, and governments from Nigeria to Venezuela, who are disrupting supply for various reasons. While these are relatively recent phenomena, the response by the governments of the US and Europe to the long predicted decline in the easily accessible oil and gas prices has been effectively zero.

Political smoke screens and by vested interests that are confusing the ‘green’ movements mean that government policy is not addressing the potentially very serious economic consequences of major disruptions to our fuel supplies in the relatively near future – within the next five years. One can only conclude after careful examination of the various options that strategic security (the business of government?) can only be met by nuclear energy fission in the short term, and possibly fusion in the longer term. Both options are being delayed by lack of government policy. It is interesting to note that, with the exception of the senior members of the Chinese Government, there is almost a total lack in Europe and America of qualified scientists or engineers in the upper echelons of government. 

These observations are likely to produce markets, which are polarised between increase in profitability in sectors relating to commodity production, engineering and infrastructure building, or in many areas re-building, while markets are likely to sag in the financial sectors and the retail areas. Economic imbalances are self-correcting and the optimistic view that one can hold in this globally connected, technology driven world, is that the correction will not be violent as knowledge and information is so widely available. While changes in trend will tend to be smoother, because of globalisation, short-term volatility could easily be exacerbated by the same technology.

Damon de Laszlo 
July 2007

DABERIAM XXXI

May 2007

The World Wide Web keeps information flowing across all borders at an ever-increasing rate, keeping Executives in Government and industry up to date and avoiding too many anomalies building up. Television around the world seems continually to reduce the amount of information it passes - sit in a foreign land and watch CNN and you have wasted a lot of time. Through all the daily noise, and particularly the agitation in the stock markets at the end of the first quarter, there continues to be an inexorable trend towards higher interest rates, but growth and profits remain steady.

Central Banks, through the global economy, are connected and are also followers of fashion, but underlying the fashion they see commodity prices rising and the inevitability of that continuing as it takes years to bring on new production, while the effects of most commodity price rises have been muted by improved product design and production efficiency. This improvement will continue for some time to come. A recent study by MIT concludes that new technological investment takes five to seven years to produce its biggest gains. In my experience it certainly takes three to four years to start getting the full benefit of new manufacturing technology in a small to medium size company. These technological gains are likely to continue to help keep inflation down in the West, provided of course capital investment is not choked off by high interest rates or Government discouragement by changing the tax rules on depreciation.*

The rise in food prices is more serious and hurting more and more people. As living standards rise in Asia there are several billion people who want more and better food. The rising food prices are also exacerbated by the green illiterates who promote ethanol production from grain in some kind of religious belief that that will save the planet.

While Iraq and Afghanistan are appalling disasters in human and political terms, the life of the majority of the people around the world is improving and there is little day-to-day pain for which Governments cannot popularise themselves by proclaiming solutions. This tends to produce a sort of rudderless Government that creates legislation to solve problems that most people haven’t thought of, the consequence is a rising tide of bureaucracy which, like the underlying inflationary trends, is hurting, but only slowly.

As always it is difficult to draw a conclusion. Will the camel’s back break and if so, which straw will cause it? If retail inflation moves up slowly, food inflation does not accelerate, and interest rates continue to rise slowly, then perhaps we are some time off from any kind of crisis. If global liquidity continues to be plentiful, corporate profits continue to improve, albeit at a slower rate, and employment in industrial and industrialising countries around the world holds up, then the Goldilocks scenario continues.

The US and the UK, where there is vast over borrowing by individuals, could experience a sudden economic crisis if interest rates move faster or the availability of credit dries up but it is unlikely to cause a major economic crisis unless unemployment also rises. One can also say that at some point private equity borrowing will cause a crisis as the investors in private equity companies and partnerships discover there is a problem trying to realise their profits. The pass-the-parcel game is now being played with larger and larger companies.

Having made all the above observations, however, one can only be optimistic as the world remains more benign than “trend” and stock markets, the most fascinating of animals, should continue their steady path.

Damon de Laszlo 
May 2007

* This is of particular concern in the UK where the Government has started to meddle in this area to raise tax revenue and the Conservative Party has floated the idea, for discussion, of withdrawing capital allowances.

DABERIAM XXX

March 2007

The year progresses with turmoil in the world stock markets and a rush of analysts casting around for a better reason than that the steady rise of the last few years needed to stop for a breathing space. However, there is some justification for nervousness.

The small waves on the surface that are upsetting world stock markets do not seem to be connected to some underlying economic themes in the deeper ocean of the world’s economy. On the surface the global economy is slowing, which is good; but there is a risk that Central Banks could raise rather than lower interest rates, as there are deep inflationary pressures that are not appearing in the way current inflation numbers are compiled.

Superficial inflationary pressures look benign as the consumer markets around the world are still being supplied with the low cost production coming out of China and the other Asian markets. While Governments are claiming credit for the low inflationary environment, everyone is experiencing rising prices in services, transport, energy, etc. Virtually all commodity prices have risen dramatically in the last twelve months owing to under investment in the last ten years.

While labour rates are relatively benign in general, there is very considerable upward pressure in skilled areas. US and UK is running pretty much at full employment, as is Europe, if you exclude what one politically incorrectly can call, the unemployable part of the population. Even China is beginning to suffer in many regions from a shortage of labour while India has a huge pool of illiteracy running into hundreds of millions of people who are not employable in the modern industrial environment at a politically correct wage rate.

All this is putting upward pressure on consumer goods prices to add to price increases in other areas. Central Banks, with their eyes primarily on inflation, are faced with the dilemma of potentially unstable asset prices, housing, etc., and a burgeoning growth in private debt which is currently hitting the headlines as well as Corporate debt being created in the frenetic takeover activities of the financial engineering community.

The much talked about Sub Prime market that is the mechanism for financing the huge increase in personal and the venture capital debt, and indeed Government debt, could subside in a period of stagflation, or in the form of a debt crisis that would liquidate hundreds of billions of dollars and euros, so reducing the world’s free supply of liquidity.

These are very old-fashioned ideas from the 1970s and 1980s. It is always worth reading history even thought it may not repeat itself, psychology tells us that humans tend to repeat their behaviour patterns. 

Taking the risk of using an overworked word, there is I believe a new paradigm that has developed since the turn of the Millennium. Globalisation has connected the world in a completely new way. The World-Wide Web means knowledge and information is universally accessible instantaneously everywhere. 

The industrialisation of China, India and other Asian countries has meant the movement of goods on an unprecedented scale and the Web has provided for the globalisation of services in a way that was inconceivable even five years ago, and is still not fully appreciated. All this means that economic pressures are less likely to build up in individual markets and continents without everyone being aware of them. 

Add to this the application of computer technology to manufacturing and you have an expansion in the ability to produce goods of all kinds at an unprecedented rate without the usual build up of inflationary pressures. While the cost of all raw materials has risen dramatically the increased productivity has kept inflation very low. It is possible that the economic development that has been the experience of the last five to seven years will continue and because of the interconnected nature of the world’s economy, the pressures that have build up will subside within the normal mechanism of the world economic model. 

I remain optimistic that this is the most likely outcome - if you can see the icebergs, the captains of ships at sea do not normally run into them!

Damon de Laszlo 
March 2007